Jake at Econompic Data had a good post on credit and equity.  (He runs a good site generally.)  They are correlated, but not all of the time.  As I commented:

When yields are low, equities thrive because financing costs are low.

When the defaults come, future equity returns are low, because financing rates rise, killing some and wounding others.

When yield spreads are very high, future equity returns are high, because returns come as spreads tighten.

You can see more on pages 14-22 of this presentation that I gave:

http://alephblog.com/wp-content/uploads/2009/11/SEAC_Presentation.pdf

Though I promised some posts after my presentation to the Southeastern Actuaries Conference, I never followed up.  Here is part of my belated follow-up.

As I noted in my presentation:

• Credit and equity returns are closely correlated in bear markets.
• Illiquidity events become more common when equity prices are falling, and credit spreads rising.
• Complexity and structure raise illiquidity during crises.
• Bonds with negative credit optionality underperform in a crisis.

I would add that credit and equity returns are closely correlated coming out of a crisis as well.  But here are some examples, starting with 2007-2009

and then 1999-2004:

and then 1989-1993:

and then 1980-1983:

and then 1969-1975:

Finally, 1927-1944:

What I concluded:

• Credit booms are different – equities rise, while credit spreads stay low and stable.
• There are sometimes exceptions when selloffs are sharp, like 1987 or 1998.
• Ignore what the government says. It is impossible to eliminate the boom-bust cycle. The best a good businessman can do is try to understand where he is in the cycle, and be prepared.
• Building liquidity looks dumb after credit spreads have been tight for a few years, but can save a lot of performance. The same is true of an “up in credit trade.”
• During the bust phase, illiquid companies and investments get whacked. It is often good to “leg into” such investments during the panic. This is when credit analysis really pays off, because during the panic, everything gets hit.
• Equity risk shows up in insurance lines of business like Surety, D&O, E&O, Mortgage, Financial, etc.
• If you have equity risk in your liabilities, reduce credit risk in your assets. Same is true if you need to regularly buy equity options. When implied option volatility rises, credit spreads tend to rise as well.

Notes:

There are few corporate yield series that date prior to 1990.  Until computers became powerful enough, bonds traded on a dollar price basis, and yields, much less spreads, were not comprehensively recorded.  One of the few corporate yield series with a long history is Moody’s Corporate Bond Indexes, which goes back to 1919.  There are some oddities to that index, but there aren’t many choices if you go back a long way.  It composed of bonds in a given ratings category, 20-30 years long, unweighted average on yields.  The averages tend to yield more than most bond managers that I have talked with think they can get.

My credit spread variable was the yield on the Baa series less that on the Aaa series.  I think it is a really good proxy for credit conditions and overall market volatility.

Anyway, this was part of a talk that I gave to the Southeastern Actuaries Conference.  I’ll do a few more posts from that, but if you want to look at the report, you can find it here.

Should regulation be dumb?  In one sense yes, in others, no.  It really depends on how well the regulators understand the risks involved, and how much they can encourage professionalism among profit center heads and risk managers.  As those two increase, regulation can be smart.  “Follow these detailed rules to calculate the capital you need to be solvent 99% of the time.”

But when either of those two aren’t true, dumb regulation may be in order:

• Strict leverage limits, reflecting the worst outcome from underwriting poor quality loans.
• Disallowing risky types of lending, regardless of capital level.
• Disallowing liabilities that can run easily.
• Disallowing products that commonly deceive buyers.
• Disallowing certain types of contracts that fuddle accounting.
• Those regulated may not choose their regulator.  The highest regulator assigns a regulator to you.  The highest regulator must evaluate the jobs that lower regulators are doing, and eliminate/lessen regulators that do not use the powers they have been granted, and get co-opted by those that they regulate.

If everyone were smart, things could be different.  Deceiving people would not take place, and managements would not take undue risks.  Limits could be looser, and products would be designed for discriminating buyers.

But, face it, we are dumber than we think, myself included.  Consumer choice is a good thing, though it implies that some will be deceived, no matter where one places the line of demarcation.  Along with that, some bank will not fit the rules and go insolvent, though it previously passed the solvency tests.

Dumb Regulation: Insurance in the US

My poster child for relatively good dumb regulation is the insurance industry in the US.  The industry is far less free-wheeling than the banking industry, and under most circumstances, the solvency margins are set high enough to have few insolvencies.  There is room for improvement, though:

• Make risk based capital charges countercyclical.  Perhaps tinkering with the Asset Valuation Reserve would do that.
• Have some sort of rigorous testing for capital relief from reinsurance treaties.
• Ban surplus notes in related party transactions.
• Ban all forms of capital stacking, especially where the transactions go both ways.  I.e., subsidiaries can’t own securities of any companies in their corporate family.  All subsidiaries must be owned by the holding company.
• More rigorous testing for deferred tax assets.
• Assets as risky as equities, including limited partnerships, should be a deduction from capital.
• Securitized bonds that are not “last loss” should have higher RBC charges than comparable rated corporates, because loss severities are potentially higher, and assets that are originated to securitize are always lower quality than those held on balance sheet.
• A standardized summary of cash flow testing results should be revealed.

As for the banks, they need to do that and more:

• Insurance companies list all of their assets.  Banks should as well.
• Intangible assets should be written to zero for regulatory capital purposes.
• Risk-based capital standards need to be tightened to at least the level of insurance companies, if not tighter.
• Some sorts of lending to consumers should be banned.  I am talking about complex agreements, that individuals with IQs less than 120 can’t understand.  Insurance policies have to be Flesch-tested.  Bank lending agreements should be the same.  If some argue that the poor need access to credit, I will say this: the poor need to get off of credit.  Credit is for the upper-middle-class and rich.  Poor people should not go into debt.
• Standardized summaries of terms and fees must be created for consumer lending, with large, friendly letters, and simple language that all can read.

What I am saying is that accounting has to be more conservative, and that regulators have to require larger amounts of capital to support their business, particularly at the banks.  Financial products must be made simpler for consumers to understand.  More transparency is needed everywhere, and if the financial companies complain, tell them that they will all be in the same goldfish bowl, so no one will gain an unfair advantage.

Preventing Too Big to Fail

As part of preventing too big to fail, the Risk based capital [RBC] percentage should rise with the amount of risk-based capital.  Say, when RBC gets over $10 billion, the percentage of capital needed for RBC grades up to 50% higher than the level needed at $10 billion by the time RBC gets up to $50 billion.

Here is my example of how it would work:

I have assumed that firms undertake their highest ROE projects first, and do progressively lower ROE projects later.  Now, by raising capital requirements on bigger firms, a common response is, “Well, then they will just take on riskier loans to compensate.”  Sorry, but that dog don’t hunt.  If they take on riskier loans, their RBC goes up even more rapidly, because loan quality is reflected (or, should be reflected) in RBC formulas prior to adjustment for bank size.

More Dumb Regulation

Dumb regulation bars certain lending practices, and raises capital levels higher than is needed over the long run.  So be it.  Smart regulation is far more flexible, and trusting that companies and consumers know what they are doing.  Unfortunately, when financial firms fail, there are often larger repercussions.  It is better to limit regulated financial companies to businesses where the risks are well-understood.  Let the less understood risks be borne by those outside the safety net, and bar those inside the safety net from holding any assets in those companies.

That brings me to the Volcker Rule, which is a good example of dumb regulation.  My preferred way would be to do something similar through adjusting the risk-based capital formulas — Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing — that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

At the Treasury meeting with bloggers in November 2009, I commented that the insurers were better regulated for solvency than the banks.  One of the reasons for that is that they do harder stress tests, and they look longer-term. Life and P&C insurers survive the process because of better RBC standards, and “scaredy cat” state regulators. What a great system, which prior to the crisis, was criticized as behind the times.  (I suspect that if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.)  The more state involvement in bank regulation, the dumber (better) bank regulation will be.

What to Do

So, if one is trying to regulate banks for solvency, there are seven things to do:

• Set risk-based capital formulas so that few institutions fail.
• Make it even less likely that larger institutions fail.
• Limit the ability of financial institutions to invest in other financial institutions.
• Regulators must benchmark the underwriting culture, and raise red flags when underwriting is poor.
• Insure that equity is truly equity.
• Institute a code of ethics for risk managers.
• Make sure that balance sheets fairly reflect derivatives.

It is almost always initially profitable to borrow short and lend long.  That said, it is a noisy trade.  Who can be sure that short rates will remain below the rates at which one invested long?  Another component of a good risk-based capital formula is that there is no investing in assets that are longer than the liabilities that fund the financial institution.  (For wonks only: regulated financial institutions should be matching assets versus liabilities as their most aggressive posture.  Unregulated financials can do what they want.  And no investing in unregulated financials by regulated financials.)

One of the great subsidies banks get is the cheap source of funds through deposits.  It is only cheap because depositors know the FDIC is there.  The FDIC should raise its fees to absorb that subsidy back to the taxpayer.  Keep raising it until you see banks begin to shift to repo and other short-term sources of funding.

As a clever old boss of mine once said, “A banks liabilities are its assets, and its assets are its liabilities.”  The idea is this — banks that focus on their deposit franchises have something of real value — that is hard to replicate.  But any bank can invest their funds aggressively, which will lead to defaults with higher frequency.  It is true of insurers as well, most financials die from bad investing policies, and short-term liabilities that require complacent funding markets.

That’s why there has to be a focus on liabilities in regulating solvency.  Financial institutions, even simple ones, are opaque.  Most die from the deadly combo of illiquid assets and liquid liabilities.  Those that have funded the bank in the short run refuse to roll over the loans at any price.  Assets can’t be liquidated to meet the call on cash, and insolvency ensues.  Those that have read me for a long time know that I don’t buy the malarkey that some managements will trot out, “We’re not insolvent; we merely have a liquidity crisis.”  Hogwash.  You took too much risk, because the first priority of risk control is liquidity management.  Assets are only worth what you can sell them for, or, what cash flows they can generate.  If assets can’t generate cash flows or sale proceeds adequate to service liabilities, then you are insolvent, not merely illiquid.

Cash flow testing for banks should focus on the ability of the bank to finance itself without recourse to selling assets.  To the extent that selling assets is allowed in modeling, they must be Treasury quality assets.

The essence of a good risk-based capital formula is that it forces intelligent diversification, and forces adequate liquidity.  No assets should be bought that the liability structure of the bank cannot hold until maturity.  There should be no concentration of assets by class, subclass, or credit, that would be adequate to lead to failure.

My view is that a proper risk-based capital regime would start with asset subclasses, and double the capital held on the largest subclass, and 1.5X the capital on the second largest subclass.  After that, within each subclass, the top 10 credits get twice the level of capital, the next 10 1.5x the level of capital.  Having managed assets in a framework like this, I can tell you that it creates diversification.

Beyond that, no modeling of asset correlations would be brought into the modeling because risky asset correlations go to one in a crisis. Any advantage derived from diversification should be accepted as earned, and not capitalized as planned for.

Securitization deserves special treatment: risk based capital should higher for securitized assets versus unsecuritized assets in a given ratings class, because of potentially higher loss severities, and assets that are originated to securitize are always lower quality than those held on balance sheet.  Capital charges should be raised until banks don’t want to securitize as a matter of common practice.

Eliminating Contagion

In order to avoid systemic risk and contagion, banks should not lend to or own other financial firms.  That would end contagion.  At least that should be limited to a percentage of assets, or through the RBC formula. Think of it this way, financials owning financials is a form of capital stacking across the country as a whole.  In a stress situation it raises the odds of a deep crisis.  Setting a limit on the ability of financials to own the assets of financials is the single most important step to avoid contagion.  I would set the limit at 5% for equity, and 20% for debt.

Regulating Underwriting

Most of the real risks came from badly underwritten home mortgage debt, whether conventional, Alt-A and Jumbo, or subprime.  Underwriting standards slipped everywhere.  Commercial mortgage lending hasn’t yet left its marks — there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.

For much but not all of this crisis, it was not a failure of laws but a failure of regulators to do their jobs faithfully.  Regulators should have looked at indicators of loan quality, and raised red flags when they saw standards deteriorating.  Where I worked, 2003-2007, we saw the deterioration, and were amazed that the regulators had been neutered.

Let Equity Be Equity

Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, and particularly, goodwill.  Equity has to reflect assets that are high quality and that are not needed to support short-term obligations from the cash flow tests.

Code of Ethics for Risk Managers

One reason the banking industry is worse off than insurance, is that they don’t have many actuaries.  Actuaries have a code of ethics.  They tend to be “straight arrows” telling it like it is.  Bank risk managers need the same thing, together with the rigorous education that actuaries receive.  Accept no substitutes: CFAs and CERAs are no match for FSAs.

Reflect Derivatives Properly

Derivatives must come onto the balance sheet for regulatory purposes, revealing leverage increases/decreases, counterparty risk, overall sensitivity to the factors underlying the contracts.  Any instrument that can cause cash to flow at the regulated entity should be on the regulatory balance sheet.

Other Issues

I would not create a prospective guarantee fund. The insurance industry has a retrospective fund that has worked fairly well.   Do you really know what it would take to create a macro-FDIC, big enough to deal with a large systemic risk crisis like this one?  (The FDIC, much as it is pointed out be an example, is woefully small compared to the losses it faces, and it is not even taking on the large banks.)  It would cost a ton to implement, and I think that large financial services firms would dig in their heels to fight that.  Also, there would be moral hazard implications — insured behavior is almost always more risky than uninsured behavior.

Though it is not bank reform, we need to end the Greenspan/Bernanke Put.  The Fed encouraged risk-taking by the banks by not allowing recessions to damage them.  They tightened too late, and loosened too early, and that pushed us into a liquidity trap. Monetary policy that is too loose creates perverse incentives for the solvency of financial institutions in the long run.

Bonuses to executives skew incentives.  Bonusing a financial executive on current earnings creates perverse incentives.  It is a form of asset/liability mismanagement, because cash flows in the short run, while the value of the institution is a long-run issue. Far better to incent using long dated restricted common stock.  The only trouble is, it doesn’t incent as well as cash.  Tough, sorry, but that is a loss that must be accepted for the good of the system as a whole.

Summary

Dumb regulation is good regulation.  Regulators should be risk-averse, and take actions that limit ROEs for banks in order to promote solvency, and reduce the likelihood of liquidity crises.  The remedies that I have proposed here will do just that.  May we use them to regulate our financial sector better, for the good of all in our nation.

My piece on bank reform will have to delay until Monday evening.  I am still working on it.  Tonight’s piece is on entitlements and pensions globally and locally.

I asked recently if anyone had data on other countries of the world to analyze where other countries were in terms of debt plus unfunded liabilities as a percentage of GDP.  I got a few good suggestions, but then I stumbled across this article in the New York Times that provided the graph to the left.

The article is about Greece, but the graph covers all of Europe and the US.  I am not sure where the author got the 5x GDP estimate for the US, but I have e-mailed him.  My own estimate was 4x GDP.

Either way the US and the EU are more comparable than different by this measure.  They are both in the 4-5x GDP zone.  But the EU contains some real basket cases such as Poland, Greece, Slovakia, Slovenia, and Latvia.  Oddly, Spain looks good on this measure, and Ireland and Italy are better than the EU average.

Now, recognize that these figures are from 2004, so they could be worse by now — they are unlikely to be better.  Here is the original article from Jagadeesh Gokhale, the fellow who calculated the European figures at the Cato Institute.  Quoting from his paper:

No EU government has made the necessary investment. As an alternative, the next-best option is for these countries immediately to gradually but significantly increase saving and investment. In particular, the average EU country could fund its projected budget shortfall through the middle of this century if it put aside 8.3 percent of its GDP each and every year. Despite this adjustment, a budget shortfall is likely to emerge after 2050, requiring additional fiscal reforms.

What will happen if EU countries do not set aside these funds? Unless they reform their health and social welfare programs, they will have tomeet these unfunded obligations by increasing tax burdens as the larger benefit obligations come due. Although spending averages 40 percent of GDP today:

• By 2020, the average EU country will need to raise the tax rate to 55 percent of national income to pay promised benefits.
• By 2035, a tax rate of 57 percent will be required.
• By 2050, the average EU country will need more than 60 percent of its GDP to fulfill its obligations.

Later, he continues:

In comparison, the United States’ shortfall for Social Security and Medicare alone has been somewhat smaller than the EU average, at 6.5 percent of future GDP. But as a result of the expansion of the Medicare program to cover prescription drugs, the U.S. fiscal imbalance is now 8.2 percent of future GDP. Putting this in perspective, to close its fiscal imbalance:

• The United States would need to save and invest an amount equal to 8.2 percent of its GDP beginning now and continuing every year forever to pay expected future benefits without future tax increases.
• This could be accomplished by more than doubling the current 15.3 percent payroll tax on employers and employees, immediately and forever.
• Alternatively, the federal government could immediately stop spending nearly four out of every five dollars on programs other than Social Security and Medicare — eliminating most discretionary spending on such programs as education, national defense, environmental protection and welfare — forever.

Each year that the United States does not take action to reduce the projected shortfall, it grows by more than $1.5 trillion, after adjusting for inflation.

If you are a wonk on these matters, I recommend that you read the paper.  But the article from the New York Times motivated the issue in other ways.  A hairdresser in Greece retires at age 50?  In the US, aside from the military, the only people I know of that retire with a full pension at age 50 are oil wildcatters, and those that similarly punishing hard work.  Also, it is backward for women to retire earlier than men; they live a lot longer.

There is no way that we are going to get governments to run 8% of GDP surpluses per year to deal with these crises.  I hate to say this, but if some of the profligate European governments want to deal with this situation, they will need to change their constitutions or laws that guarantee pension payments at a certain level and age, and extend the age and drop the benefits.  Political suicide, I know.  But do you care if the Eurozone fails?  Do you care if your nation fails?  I’m not saying that one group has to bear pain while another does not, but aside from those that work at physically demanding jobs, there is no reason why everyone can’t work until age 75.  Yes, 75, leaving aside disability.  Retirement should be the last 10 years of life on average, not the last 20, much less 35.

When someone stops working, the rest must pick up the slack.  Is there any way for a culture to work where those who work must support 2+ people excluding themselves?  Many Western governments are staring at cultural failure, and can’t see the forest for the trees.  They see the short run funding difficulty, but do not see the long-term problem that is lurking to begin to bite in the next decade.  The sad thing is — it’s too late.  Aside from cutting benefits, or raising benefit ages, there is no way out.

The Divided States

The Barron’s cover article dealt with high state and municipal pensions.  Though I wrote a piece on this recently, talking about the Pew report study, among other things, this article makes the valid point that the state and municipal discount rates on pension liabilities are likely too high, averaging 8% or so.  The nominal GDP growth rate of the economy of the whole is probably the best estimate of where discount rates should be — what shall we say? 4-5%/year?  In this low rate environment, earning 8% forever is ludicrous.  But at 4-5%/year we are talking about a deficit of ~$3 trillion, not $1 trillion.

As the article points out, workers in the public sector earn more on average than those in the private sector.  The need to have high pensions to attract workers is no longer valid.

Also, the states and municipalities are taking above average risks to try to earn their target rate, even though doing so is highly unlikely.  As it says in the article:

Finance professors Robert Novy-Marx at the University of Chicago and Joshua Rauh of Northwestern University asserted in a recent paper that the funding gap for state pension plans alone might exceed $3 trillion, in part because state funds are using an unrealistic long-term annual investment return of 8% to compute the present value of future payments to retirees, as is permitted in government standards for pension-fund accounting.

This establishes a “false equivalence” between pension liabilities and the likely investment outcomes of state investment portfolios, which are increasingly taking on more risk by beefing up their exposure to stocks, private-equity deals, hedge funds and real estate. Using a much lower expected return — say, one at least partially based on the riskless rate of return on government securities — would both properly and dramatically boost the present value of the pensions’ liabilities while decreasing their likely ability to meet them. The academic pair, using modern portfolio theory, claim that state funds, as currently configured, have only a one-in-20 chance of meeting their obligations 15 years out.

As I said above with countries, so it might be with states.  Some states will have to repeal statutory or constitutional guarantees on pensions in order to survive.  I don’t like saying this, but I don’t think there is any choice eventually.  Do you want your state or municipality to survive or not?  Even Chapter 9 and/or ERISA should be amended to allow for adjustment of pension obligations in municipal bankruptcy.  States also should be able to use Chapter 9, or, a new Chapter of the Bankruptcy code for States.

That is why bond investors are getting skittish over General Obligation bonds, and moving to Revenue bonds, if the revenues are stable enough, and protected for bondholders.  They don’t trust the states and municipalities.

Now, this comes after years of underfunding the pension funds.  Few truly were farsighted, and set aside the assets, rather than having more current spending, or deceasing taxes.

Where does this leave us?  In no good place.  Is there a solution?  Yes, but only that of shared pain.  We have to decide whether we take structured pain now, through benefit cuts and higher taxes, or, take unstructured pain when the riots arrive, time to be determined.  Cultural failure is a real possibility; civilization is more veneer than solid when everyone argues for their self interest, and few argue for the good of the whole.

I will have a more comprehensive post tomorrow on my thoughts on bank regulation, but I will offer a few thoughts here.  One thing I found interesting at the conference was what did not get much play in terms of what helped to create the crisis.

It was fascinating that no one talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries. This is significant.  The moment you put money into a holding company, it goes everywhere.  Regulators should only care about operating subsidiaries, and let the holding companies fail; let the costs be borne by the stockholders and bondholders of the failed company, but protect the regulated entities.

Also, few fingered the Fed’s monetary policy, where Greenspan and Bernanke created a culture of lenders who knew that the Fed would ride to their rescue when thing got modestly tough.  Unlike William McChesney Martin, who joked that the Fed’s job is “to take away the punch bowl just as the party gets going,” Greenspan and Bernanke were slow to remove the punch bowl, and quick to bring it back, creating lenders who would rely on the Fed to allow them to take too much risk.

Another miss was not blaming the failure of neoclassical economics to explain, much less predict the problems that we experienced.  Why invite any neoclassical economists at all to the conference?  The few economists that were ahead of the asset bubbles were ignoring neoclassical economics.  Neoclassical economics is a failed discipline that needs to be replaced by something that realizes that applying math to economics does not yield significant increases in understanding.  The Austrians, those who follow Minsky, and the non-linear dynamic school understand what is going on better, because they treat economics the same way we understand ecology.  And, no, applying math to ecology doesn’t help that much.

Preventing Too Big to Fail

There are three main ideas as I see it, in preventing “Too Big to Fail.”  The first is changing risk-based capital [RBC] policy to raise capital requirements on larger institutions.  Use RBC to discourage banks from getting too large.

The second idea, which also wasn’t talked about much at the conference, was to limit regulated entities from owning or lending to other financial institutions.  Do you want to limit contagion?  Well, if you do, you must limit the amount that regulated banks own of/lend to other financials.  That even applies to subsidiaries with the same ownership group.  Keep it clean.  If you are going to have financial holding companies let them own all subsidiaries directly to avoid capital stacking.  Ban cross-guarantees among subsidiaries.

The third idea, which I have touched on is that regulators should ignore holding companies and never, never, NEVER bail them out.  Bailouts should only come to regulated entities, and only after the resources of the holding companies have been drained to zero.

On Detecting Fraud

I appreciate what was said on detecting fraud by one presenter: check for adverse selection, honest businessmen won’t do business that way.  Also, it never make sense for a secured lender to accept inflated appraisals.  In short, the originate to securitize model allows originators to make substandard loans that they will not hold onto.

This is why I say look for gain-on-sale accounting. There is something perverse about making money simply because a sale is made.  Under the GAAP principle of release from risk, which I believe is misapplied, financial entities should recognize profits more slowly than is the current practice.

When I was a buy-side analyst, I would analyze a company’s management culture for short-termism. Any management team that seemed too aggressive would get negative marks in my book and I would avoid them, or short them.

Remember you can never get pricing, volume and quality at the same time in lending. Companies that go for volume, or sacrifice quality are begging for trouble.  Financial companies are in a mature industry, so beware companies that grow fast.  Also beware of long dated accruals.  Accrual quality declines with length of time until payment and likelihood of payment.

Those that want to have regulators war-game future problems and predict black swans have their work cut out for them, even considering what I have said already.  But most of their attention should be fixed on the areas of the market where the greatest increase in lending is occurring.  Where debt is increasing the most is usually the area where there will be the most financing problems in the future.

One more note for regulators: look at the high short interest.  The shorts are doing you a favor.  They spend a lot of time analyzing who they think is cheating the system, and then they put their money on the line.  I would tell regulators to use the shorts as a guide.  Don’t automatically trust that there is something wrong, but use it as a guide to now begin your own due diligence into the solvency of the financial institution in question.

More Tomorrow — until then.

Carl Felsenfeld: Do we know what the problem is?  What are we trying to solve?  Antitrust does not deal with Citigroup/Travelers, it should deal with Bank of America/Fleet, Wells Fargo/Norwest.  But it didn’t deal with those bank acquisitions.  The regulators were out to lunch.

Jesse Markham: Antitrust can only do so much. It also does not do so well where size is due to organic growth.  (DM: like Google or Microsoft.)

Zephyr Teachout: Antitrust should be based on size.  The DOJ is less subject to regulatory capture, and more inclined to prosecute.

Paul Kaplan: These ideas are against current trends in antitrust.  Perhaps a more rigorous application of the Sherman Act would be more effective.  Organic growth to a large size is still a problem, but how do you avoid punishing success?

(DM: just met Colin Barr of Fortune.  Nice to put a face to the name after all these years.)

Discussant: Canada disallowed securitization for the most part, and stopped more mergers with their banks.

False Assumptions

William Black — Control Fraud & Systematically Dangerous Institutions -Accounting values can be fudged.  RBC as well.  Difficult to detect Control Fraud.  Originating bad loans allows a bank to grow rapidly.  Need forensic accountants.

(DM: look for fast growth — quality, quantity, price. Look for new products.)

Lawrence Baxter — When Big Becomes a Problem.  – Worked ten years at a major bank that went through  a ton of mergers.  The self-regulations with each bank having its own risk model doesn’t work.  The regulators don’t understand them, and spend time learning what is going on.

(DM: fascinating that no one has talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries.  Also, few have fingered the Fed’s monetary policy.)

Shawn Bayern — False Assumptions in Law and Economics — Innovation in the banking is not always a positive.  Bonuses to executives skew incentives.  (DM: it is a form of asset/liability management.)

Russell Pearce — discussant — Business is self-interested, and short-term greedy.  Profit-making is maximized, not even long-term greedy (DM: maximizing the net present value of profits).  (DM: incent using long dated restricted common stock — trouble is, it doesn’t incent as well as cash.)

Mark Gimein — discussant — 3 questions a) What of a big rogue banker?  The market is good at absorbing single failures.  (DM: but not multiple failures.)  b) who should do the regulation?  Tough to get bright men who are tough who won’t go to work for the banks, or buy into the banks logic. c) Control Fraud is hard to prevent; human nature is that way.  No systematic approach to dealing with fraud.

Detecting Fraud — check for adverse selection, honest businessmen won’t do business that way.  Also, it never make sense for a secured lender to accept inflated appraisals.

(DM: Look for gain-on-sale accounting.  Analyze management culture for short-termism.  Remember you can never get pricing, volume and quality at the same time.  Financial companies are in a mature industry, so beware sompanies that grow fast.  Be aware of long dated accruals.)

Discussant — are we worse off today than in the robber baron era? Not necessarily.

Holmes bad man theory — the law exists to constrain bad men.

I gave a 3-minute rant on how insurers are better regulated than banks.  I’ll write more about that tonight in a piece that articulates my views on banking reform.

Simon Johnson’s lunch talk was pretty standard: there is no social benefit to banks being larger than $100 billion in assets.  Major banks are too politically powerful, but they should be fought the same way Teddy Roosevelt did with JP Morgan and trustbusting.  Simon thinks that political opinion is shifting on this issue.  He calls for a size cap based off of a 4% percent of GDP for commercial bank assets, and 2% for investment banks.  This would only affect 6 banks, and would put the banking system sizewise where it was in 1990.

A frequent comment is that Canadian banking is concentrated, and they haven’t been hurt.  But other nations have concentrated banking and have gotten into trouble, notably Switzerland and the UK.

One commenter noted that reliance on wholesale funding drove much more of the panic than deposit funding.

Now the third panel starts:

Rob Johnson spoke about creating a credible resolution authority.  He asked why we can’t send Large Complex Financial Institutions [LFCI] through Chapter 11?  Derivatives must be simplified and brought into clarity.  Contagion, complexity, etc.  No real solution offered.

Jane D’Arista — Financials cannot insure other financials.  Leverage must be scaled back.  Various types of short term funding must be scaled back.  Margin standards must be extended to all financial instruments.

Richard Neiman — Banks are risk-takers, that provide a social service, thus taxpayer guarantees via the FDIC.  Volcker rule may not have prevented the last crisis, but it might prevent the next.  Need a group to try to be proactive on future risks — war-gaming.  Attempt to predict black swans.

(DM: most of this can be done by following increases in leverage.)

Arthur Wilmart: no magic bullet.  Fed overstimulated housing market after dot-com crash.  Reduce implied subsidy to banks.  How to internalize the costs?  Three problems on deposit limits: failing banks, intra-state acquisitions and thrifts aren’t counted.  Narrow banking would contain the subsidy.  Systemic risk insurance fund — at least $300 billion, pre-funded.  FDIC would manage it — most competent of the regulators.

Frank Pasquale — Talks about information asymmetries, need more disclosure.  Financial privacy — banks that are big would have to reveal a lot more.  Records of everything would have to be kept for a long time 10-15 years.

A discussant: choosing the lax regulator (DM solution: government assigns the regulator)

DM: banks should not lend to or own other financial firms.  That would end contagion.  At least that should be limited to a percentage of assets, or through the RBC formula.

One panelist suggests that all financial instruments be traded on exchanges.  (Ridiculous, because only common instruments can can trade on exchanges.  Unique things don’t trade on exchanges.  That’s why IBM equity trades on an exchange, but most IBM bonds don’t.)

Discussant: banks cannot self regulate, not even as a group.

Cheapest source of funds are FDIC-backed deposits.  That’s the big subsidy.  (DM: Charge a much larger FDIC fee.)

Discussant: won’t narrow banking create more risk outside the banks?  Where things are less regulated?  Those losing money outside of the banks would end up taking a haircut.

Discussant: GS or MS failing would still shake the system.

Discussant: a new insurance fund would be difficult to make work.  Also,a new regulator might not be better than existing regulators

Discussant: Regulating money market funds as banks.  (DM:  money market funds lost so little, and banks lost so much… why is this an issue.)

Cornelius Hurley argues that banks are implicitly and explicitly subsidized, and that they need to return the subsidy.

Dean Baker argues for a transfer tax, and weakening the political power of financial institutions.  Really tangential to the point of the conference.  I’m not sure it would help or hurt too much.  It would drop trading volumes.

Dana Chasin argues for more centralized information analysis to deal with opacity and interconnectedness.

Ron Feldman argues that plans should be made in advance for how to wind up firms, based on what is special about the firms aka “living wills.”  Suggests that resolution regimes are too vague.

Tamar Frankel argues that banks should bail out each other, but pay differential guaranty fees based on the riskiness of each bank.  I think that would be difficult to pull off, such a strategy hasn’t worked that well for the PBGC (not equally funded), State Insurance Guaranty funds (post-funding), or the FDIC (pre-funded but equal contributions).  There are moral hazard and agency problems with this idea.

Personally, I would make the Risk based capital [RBC] percentage rise with the amount of risk-based capital.  Say, when RBC gets over $10 billion, the percentage of capital needed for RBC grades up to 50% higher than the level needed at $10 billion by the time RBC gets up to $50 billion.

One questioner suggested unlimited liability for bank shareholders.  That sounds like requiring the investment banks to be partnerships.

Another mentioned the trouble with state guaranty funds in the ’80s.

Also, more capital needs to be held against securitized assets versus non-securitized assets.

One commenter suggested making repo funding unsecured.  Oh my.

Another guy commented that having subordinated debt as a warning sign did not work in the past.

Another commenter said that liquidity always dries up when you need it most.

There are always a few loonies at conferences, who know nothing about the topic at hand.  It keeps things colorful.

At the end of this panel, Heather McGhee of Demos came to talk about Financial Reform in DC.  Snapshot:

• Non-compromise Dodd bill coming Monday — no systemic risk regulator, but a systemic risk council.
• Standardization of derivatives trading, clearing, etc.  There will likely be end-user exemptions.
• Prudential regulation ~20 big financial companies will be regulated by the Fed.
• New special bankruptcy court — a check to determine illiquidity or insolvency.
• Possible Prop trading amendment — the Volcker Rule, with regulatory exceptions.
• Possible amendment: Size cap on assets, unlikely to get made into law.
• Possible new resolution authority.

Difficult to see how proactive financial services regulation gets enacted… politicians and regulators tend not to be forward looking.

First panel deals with

James Kwak: Funding costs were overly low at the major banks.  Alleges too big to fail, but big banks were highly rated.  My experience is that small banks equally good as large banks have much higher fundung costs.

Richard Carnell: hits the nail on the head — Regulators had the power to act and did not.  No political constituency for tight capital standards and higher capital levels.  So bankers argue from a concentrated political interest, and there is no political interest for solvency in good times.

F.M. Scherer — argues that too many mergers were allowed to occur, and that there were too much profits in the financial sector.  Not sure why this guy was invited.  Very long-winded, but with little new thought.

Jennifer Taub: focuses on the repo market and other short-term financing markets.  Why do banks get to finance long assets short?  Really seems to be a failure of basic Asset Liability Management.

Elizabeth Nowicki: Directors and Officers need liability and personal penalties like disgorgement of bonuses for excessive risk taking.

Good bond investors ignore ratings and read reports.  Rating agencies get blame, but much of it should go back to the regulators who require use of ratings.

Focusing on assets is a loser here, because it is liquid liabilities that lead to failure.  Focusing on funding structures would have the greatest impact on solvency.

Dean Baker makes the good point that the Fed Chairman and other regulators should have been fired as well.  Carnell added that the three thrift regulators appointed by Reagan — the first two were destructive, but the third got the blame.

Commenter/questioner brings up off balance sheet liabilities.  All assets and liabilities that affect cash flows should be brought on balance sheet for regulatory purposes.

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Okay, here is tonight’s rule:

The assumption of normality for asset price changes is wrong in virtually every financial market setting.  The proper distributions are fatter tailed and more negatively skewed.

Normality allows researchers to publish, regardless of the truth.

Normality allows risk managers and regulators to pretend that adequate reserves are held against disaster.  It also allows businessmen to achieve acceptable ROEs, while accepting a probability of ruin far in excess of what is prudent.

The normal distribution is a wonderful creation, because it is so simple.  All we need to know is the mean and the variance, which are very simple to calculate.  And… it seems close to fitting a large number of phenomena in nature where the behavior of one party does not affect the behavior of others.

But in economics and finance, the assumption of normality is perpetually violated.  I would guess that it is wrong more often than it is right.  Academics continue to drag out studies assuming normality because it allows them to publish.  academics get statistically significant results more often than they should, because they pursue specification searches, and get to results that they can publish via data mining (and ARIMA error terms — unless there is an a priori reason them, they facilitate specification searches).

And, lest I be accused of being merely biased against academics, this biases me against many businessmen as well.  Many bankers looked at their loss distributions over the prior 25 years in 2007, and assumed that risks were minuscule.  Yes, there were bad periods, but the Fed always rode to the rescue, and losses were low, aside from a few egregious offenders.

Bankers concluded that they could do no wrong, and underwriting suffered.  Rather than looking at more objective measures of risk, bank managements looked at the need to hit their earnings estimates.  Losses had not been large in the past, so the future should be equally good.

When I was a risk manager, I would look at the level of surplus, and would compare it to expected normalized annual losses — if I didn’t have at least 15x normalized annual losses, then I knew I could not survive a reasonably normal spike in defaults at the bottom of the credit cycle, though an assumption of normality, where losses don’t come in bunches, would have allowed me to lever up more.

And I have known my share of management teams that pushed at the risk manager, telling him he was too conservative.  The company couldn’t earn an adequate return on capital at such low levels of leverage.  Equity analysts expected constant growth out of financial stocks, which sadly are cyclical stocks — it is a mature industry, and mature industries are cyclical by nature.  So they added more leverage, and things worked well for a while, until things blew up.

So long as consumers felt that they could add more debt, the bet could go on, with occasional minor interruptions while the Fed mopped up the damage.  But that stopped when the Fed could not drop rates below zero.  Still, the Fed found new ways to subsidize the debts of privileged parties, by buying up their long term debts and holding them.

Look, if you want to regulate properly, you can’t rely on normality.  It does not work in finance and economics.  When looking at loss statistics, don’t look at the mean or the variance.  Instead look at the maximum 3-year loss, and gross it up by 20%.  The surplus of a company should be able to absorb the maximum amount of losses from 3 years, and then some.  I use this as an example rule; tailor it to your needs as you see best.  I used 3 years because the bust phase of when the credit cycle is rarely severe for more than 3 years in a row.

If you want to manage risk internally properly you should think similarly — look at the outliers, and ask whether you can survive something worse than that.  Here’s a personal example: if someone had come to me two months ago and asked me how likely it would be that my area near Baltimore could get 60+ inches of snow in a one week time span, I would have said, “That’s not impossible, but that is way beyond the prior record, which I think is around 30+ inches.  Very unlikely.”  Well, it happened, and five weeks of warmer weather later, my backyard is still half covered by snow.

Markets, like the weather, are far more variable than we would like to admit, and attempts to tame them often lead to suppressed volatility for a time, but with explosions of volatility later, as economic actors begin to presume upon the low volatility as their birthright, and begin to speculate more aggressively, building up progressively more leverage as they go.

So when analyzing risk look at the worst possible outcomes, and build a plan that can handle that.  Size your leverage to reflect that; in a really risky business, you might have no leverage, and extra bits of slack capital in high-quality short-term debt claims.

Finally, remember my analogy of bicycle versus table stability.  A bicycle has to keep on moving to stay upright. A table does not have to move to stay upright, and only a severe event will upend a large table.

I developed this analogy back when I was a corporate bond manager, because there were some companies that would only stay afloat if they kept moving, i.e., if operating cash flow continued at its projected pace. That is bicycle stability; they have to keep pedaling. There were other companies that could survive a setback in earnings, and even lose money for a time, and the debt would still be good. That is table stability.

This is why stress-testing beats value-at-risk in a crisis, and why the insurers came through the crisis so much better than the banks.  When liquidity disappears, strategies that require continued liquidity can cause their companies to disappear.

Better safe than sorry.  Banks should run their businesses using stress tests that will cause them to have lower ROEs because of the additional capital needed to assure solvency.  The regulations have been too loose for too long.

Before I start tonight, a reminder, those that want to follow me on Twitter can do so here.  I will be sharing posts and ideas that I find insightful, that I might or might not share on the blog.  I’m still working with it.  Thanks to all of those that tweeted and retweeted, and those that are following me now.

One more note, I disagree with Volcker and Sarkozy regarding supporting Greece, versus the Euro.  If Greece defaulted, Greece would lose the low cost funding of the Euro.  The Eurozone would lose a country, but the Euro would retain its strength, and marginal nations prone to cheating would come into line.  Tough love is the best policy; don’t bail others out if you care about the union as a whole.

On to tonight’s rule: Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.  If the speculator is undercapitalized, risks to the financial system rise.

This rule is pretty simple.  There are few places in the financial markets where there are naturally offsetting exposures that have not been remedied by an institution created for that very purpose, such as a bank.  In most cases with derivatives, the one that wants to reduce exposure relies on a speculator.  There are rare cases where the risk of one is the benefit of another, but situations like that tend to create new firms to internalize the trade.

The trouble occurs when the speculator can’t make good on his obligations.  As with many speculators, he overcommits.  He is short of funds because many trades are going against him at the same time.  It is in these cases that those who hedge learn to evaluate counterparties for their riskiness.

That is why it is worth knowing who is at the end of the chain in this financial game of crack-the-whip.  The status of the ultimate speculators, and whether they can make good on promises or not is a huge thing.  After all, subprime mortgages were downplayed by many as the crisis was rising, but they were at the end of the financial game of crack-the-whip.  They were one of the main classes of marginal borrowers.

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Taking this a different way, this argues against the academics that look for complete markets in the sense of Arrow-Debreu.  There are trades that no one wants to take at any price that a seller could live with.  There are securities that can be created that no one wants to buy, at prices that are unprofitable to the securitizer.    Complexity is a minus.  We can create securities that are the financial equivalent of toxic waste, but no one should pay much for them.  It is the price of creating safe securities.

No surprise: people pay a lot more for certainty, even if it is seeming certainty.  We see it in corporate bond spreads.  High quality borrowers borrow cheaply.  Low quality borrowers pay up. So what else is new?

What is new is the low-ish spreads for going down in quality.  This one could go either way; spreads are wide against history, but might be narrow against current difficulties.  The rebound has been rather sharp.

Note: this is reposted because of a system glitch.